As always, the Markit Purchasing Managers Indexes are some of the first data we receive about a month. The November preliminary readings came out today and from the perspective of the global business cycle, it is hard to find good news in there. All the PMIs released were lower than their final number for October. The upticks we saw in the Eurozone and China appear to have been reversed.

Source: Markit, Bloomberg, Astor calculations

In the heatmap above bright green shows the US as the strongest market, consistent with its place throughout the year and with what most analysts are expecting for 2015. The muddy colors of Europe show most around the 50% expansion /contraction line, with France setting a new low for the year. Interestingly, There does not seem to be much evidence of deterioration in Japan over the last six months, giving hope that the two consecutive quarters of negative growth will soon be reversed

The time series below shows a different view of the big three, US, Eurozone and China. All off their recent highs and the Eurozone and China close to the contraction line.

Source: Markit, Bloomberg, Astor calculations

I am concerned we will see additional deterioration in coming months, though there is currently no sign of a dramatic plunge in manufacturing activity.

Two authors I respect very much have post I would like to argue with a bit. The different response to the US economy to dramatic stock market declines in 2000-2002 and 2007-2008 is very interesting, what does it tell us about the US economy?

Cecchetti & Schoenholt say that the story is all about leverage in the financial system and surely that is part of the story. In Mian & Sufi’s excellent book House of Debt tells a story I find more convincing about leverage. The key thing is not how much debt is held, but who is holding it. Yes, banks had leveraged exposure to US real estate prices in the period leading up to the Great Recession. Consumers, however, had a great deal more exposure to relative to shock-absorbing assets. Mian & Sufi argue that the lower income consumers who had borrowed to buy homes were forced to dramatically curtail their spending after the decline in price of homes they bought with borrowed money.

Imagine you make $10,000 a year and you make a $10 bet. If the bet turns out against you it would not affect your lifestyle very much. Now imagine the losing bet was $1,000, in this case your pattern of spending would have to change a great deal.

Mian & Sufi make a case that this is exactly what happened in the 2007-2009 crisis. Debt acted as “anti-insurance” – focusing losses on those least able to bear them, with results that are readily understandable in retrospect, even if they were not well understood at the time.

How much debt was added and are we back to more sustainable levels? Since 1980 the Federal Reserve has published data about debt relative to income.

We can see that the total of all interest payments (mortgage, student debt, credit cards etc) as a percentage of income has swung from a high over the life of the series in 2007 to a new low value today – a function of the mixture of lower interest rates and lower rates of debt. As this measure has been fairly table for several quarters, it seems that consumers do not feel the need

I recommend House of Debt (or their academic writings, accessible here) to everyone in the financial services industry, that Cecchetti & Schoenholtz talk about asset returns on the economy and not to mention the composition of the debtors shows that their work has yet to be fully appreciated.

The big decision for the Fed next year will be if they should start raising interest rates. Remember that the fed is charged to try to maintain price stability and full employment. This chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.

The argument for raising rates is that it is necessary to control inflation. This this post from The Economist for example. I disagree for a few reasons:

As the chart below shows, over the last 20 years actual inflation has spent a good deal of time below a band around 2% inflation except and only brief episodes above, suggesting that the Fed is too hawkish on average.

There is mounting evidence (for example this note published by the Fed) that the recessions, the possible outcome for raising rates prematurely, can involve permanent reductions in the level of output. Simply put, if you have a million people working for a year they make a certain amount of stuff. If there is a recession and they are out of work, they don’t make up all of the lost output once the economy recovers. To take this risk the threat to price stability must be substantial.

Of course, what I think doesn’t matter, only the opinions of the voting members of the FOMC count. Every year a shifting cast of regional presidents serve as voting members on the FOMC. This year sees 4 new presidents along with the chair of the NY Fed who is always a voting member in deference to that bank’s constant connection with the markets. We have two members I would characterize as patient about raising rates and two who seem eager

Richmond Fed’s Jeffrey Lacker says that “the unemployment rate is an accurate gauge of labor underutilization. ” Suggesting that rates can rise soon. Interestingly, he not only expects to raise rates, he wants the Fed to sell securities held under quantitative easing, not just cease to purchase. “I believe the Fed’s efforts to normalize monetary policy must include the sale of mortgage-backed securities in order to reduce the Fed’s role in credit allocation. ” Lacker speech

On the other hand Chicago’s Charles Evans sees risks to tightening: “I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time.” And he emphasizes caution: “As I think about the process of normalizing policy, I conclude that today’s risk-management calculus says we should err on the side of patience in removing highly accommodative policy.” Evans speech

At the Federal Reserve bank of Atlanta Dennis Lockhart believes the United States will approach conditions consistent with full employment by late 2016 or early 2017 and in his view undershoot of the inflation target is currently a bigger risk than overshoot. Lockhart speech

The New York Fed president William Dudley seems to be willing but not eager to raise rates next year: “The consensus view is that lift-off will take place around the middle of next year. That seems like a reasonable view to me. But, again, it is just a forecast. What we do will depend on the flow of economic news and how that affects the economic outlook” Dudley speech

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

If he is using this as a reason to raise rates, I cannot agree. First of all, surely a decline in inflation risk premiums means that the market is less concerned about sudden jumps in inflation. That is, the market is telling you that the market is not worried about inflation. I am not sure why a policymaker would want to discount that. Second, it is not clear that Survey based inflation expectations are indeed stable. See this chart of expectations for next year from the Consensus Economics survey.

Whatever is ahead, our next landmark is the final FOMC meeting of 2014 which will feature new forecasts from the committee members and a Janet Yellen press conference on December 17. Hopefully we will get more insight into the Fed’s plans then. In the meantime it is worth noting that for Fed Funds to get to what the median member expects of about 1% by the end of 2015 and they proceed in bite-sized 0.25% steps, they will need to start raising rates in their fifth meeting of the year in July. Given the Fed’s reluctance to surprise the markets, I would expect clear warnings at the March press conference at the latest.

Interestingly, the Fed Fund futures seem to expect less easing overall with year-end 2015 rates in the market at 0.5% which implies starting later or not raising rates at every meeting after they start.

Pending home sales are a noisy number to follow, but there was an interesting piece of information within the information. According to the real estate agents who were surveyed for the index, approximately 15% of the deals they were involved with did not close due to the buyer not being able to secure lending. Credit remains tight, however, there are signs we could see looser practices coming. Two weeks ago, regulators decided to remove a requirement for a 20% down payment in order to obtain a high-quality mortgage. Fannie and Freddie followed with an announcement that buyers could obtain lending for as little as 3% down. Hopefully the mortgage industry can contain itself this time around and not offer no money down, no proof of income loans.

Housing prices continue to moderate as the industry recovers. Monthly changes in the 20 city Case-Shiller composite have fallen sharply since March. The YoY change falls lower as each month passes, which means we are out of the bottom zone and will likely not see double digit gains in the future. As long as employment stays healthy, wages inch up, and lending loosens; softer prices should bring more buyers to the table.

The headline number paints a worse story than the underlying data. Excluding the transportation sector, orders slipped 0.2% in September. The majority of the top level decline was attributed to a 3.7% decline in transportation orders. Business investment was weaker (-0.2%) so we will keep an eye out next month to see whether the trend is reversing or if spending cooled off after large increases earlier in the year. Growth on an annual basis appears to be strong. For now, we will consider the trend to be intact.

We are starting to look a lot better on an annual basis than we thought we would, especially given Q1’s issues. We still are stuck in the low-2% YoY growth environment though. The last two quarters certainly help to bring us up to this level from where we stood in the spring but how do we move past it? QE ended and the global economy is consistently shaky. Where do we go from here? The U.S. economic engine appears to be catching its wind again, but it has been a slow and painful process. Q3 experienced growth from personal consumption, exports, and government spending. Inventories negatively contributed which was expected after a 1.42% increase in Q2.

If you pulled a Chicken Little on October 15th, you’ve probably had to blink twice last week if you looked at the S&P 500 Index’s closing price for the month. October was one of those months you should have only looked at the first day and the last day. If you paid too much attention to the in-between, you might have panicked. What appeared to be a straight shot down mid-month turned into a month of almost 2.5% in gains for the Index. On absolute point basis, the S&P 500 took a 150+ point dive to the lows and then recovered nearly 200 points to give a open-low-close range of around 350 points. In a reverse course of the action seen most of the year, small caps lead the way with mid caps and then large caps trailing behind. The Russell 2000 Index (i.e. small caps) flew to a 6.5%+ return on the month to bring the gap between large and small cap stocks to a much narrower 8.3% from a high of 12.6% reached early in the month. The question to answer now is “Why did we rally?” There are plenty of reasons to give here and I would not feel comfortable pinpointing a specific headline or event. Corporate earnings were good, Japan looks to be entering into more stimulus, the Fed here seems to still be on course for a mid-2015 rate hike, news from emerging and developed markets were better, investors bought the dip, etc, etc.

LOOKING THROUGH THE WINDSHIELD

Economic

A good chunk of the data is already out for the week but many reports remain on the schedule. Nonfarm payrolls will be a big focus on Friday as well as other employment numbers (wages, participation rate, etc.). I doubt we will see runaway wage inflation, but the market is jittery right now when it comes to rates so there are a lot of eyes on those types of numbers. ISM Non-manufacturing will notch another month above 50 and get closer to 60 consecutive months in expansion territory.

Market

A week of muted price movement would do us all well. I think we could use a breather after October’s wild ride. Time to reset, look to the future, and move forward with what is increasingly looking like a solid domestic economy. Keep a watch out for the dispersion between large, mid, and small cap stocks. We are firm believers of mean reversion here. Large caps could pull in or stay flat while smaller company stocks move higher. Fears about a higher USD impacting earnings for large multi-national companies will continue to give reason to buy small.

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